How to manage a financial crisis – why didn’t the Fed’s QE cause hyperinflation?

Because no one was spending it.

Many were worried the extreme liquidity measures of the Federal Reserve during and after the GFC would lead to hyperinflation in the US. Or that it represented a currency war, where the US was seeking to deliberately over-inflate their economy to drive down the US dollar, as well as reduce their real debt burden, at the expense of the rest of the world.

It has happened so many times through history and the world, where inflation was triggered by excessive money creation:

·         Before the American Revolution, tobacco was used as currency in Virginia, Maryland and North Carolina. And because the price of tobacco was originally greater than the cost of growing it, planters set about producing more. This caused the supply of this “currency” to expand faster than the rest of the economy, causing the price of everything for which tobacco could be exchanged to increase 40-fold.

·         When gold was widely accepted as legal tender, huge gold discoveries in Mexico and South America in the Middle Ages, and in California and Australia in the mid-19^th century, effectively increased the money supply, setting off inflation.

·         After WWI, Germany printed extraordinary quantities of money to pay the huge war reparations demanded of them under the Treaty of Versailles. So from 1914 to 1923, wholesale prices increased by a factor of 726 billion – that’s 72.6 trillion per cent inflation. The US dollar went from buying 0.2-0.25 Mark to 4-5 trillion Mark. There were stories of people in Germany carrying wheelbarrows full of cash to buy a loaf of bread, getting mugged for the wheelbarrow instead of the cash.

·         It has even been observed in prisoner-of-war camps, when cigarettes were used as currency. Upon a new delivery of cigarettes to the camp, the price of whatever they traded for the cigarettes would jump.

·         The hyperinflation in Zimbabwe and, more recently, Venezuela was also driven by excess money creation by their central banks.

The fact is, until the GFC, there was not a single example in history of a “rapid increase in the quantity of money that was not accompanied by a roughly correspondingly substantial inflation” (M&R Friedman).

But it didn’t happen this time in the US. And there were actually good reasons to know that it never would. First, a bit of theory – specifically, the Quantity Theory of Money:

%∆M + %∆V = %∆P + %∆T.

This means that the percentage change in the money supply (M) plus the percentage change in the velocity of money (V) (how many times each dollar is spent per year) is equal to the percentage change in the price level (P) (a.k.a. the inflation rate) plus the percentage growth in the size of the economy (T) (a.k.a. the economic growth rate).

Let’s put some standard numbers to the variables:

5% + 0% = 2% + 3%.

So if the central bank is expecting an economic growth rate of 3%, and for the velocity of money to remain constant (reasonable in normal times), then they need to increase the money supply by 5% to achieve their target inflation rate of 2%.

If the central bank happens to increase the money supply by, say, 10%, all this extra purchasing power in the economy will drive up inflation by 7% (assuming economic growth and velocity remain at 3% and 0% respectively).

The Quantity Theory of Money is a mathematical certainty. It has to happen. And not even necessarily with a particularly long lag. Other things being equal, an increase in the rate of money creation will inevitably result in an equal increase in the inflation rate.

It is easy for governments to blame inflation on trade unions, greedy businessmen, spendthrift consumers or anything else that seems remotely plausible. But these groups can’t produce continuing inflation for the simple reason that they don’t possess a printing press with which to affect the money supply.

As Milton Friedman said:

“Substantial inflation is always and everywhere a monetary phenomenon”

So why then, when the Federal Reserve effectively increased the money supply in the US so dramatically, did it not result in inflation and a depreciating US dollar?

Because of the one variable we’ve been assuming to be constant – the velocity of money.

A recession, by definition, occurs when there is less spending in an economy than there was before. Each dollar is being spent fewer times per year. This is the velocity of money. And during the GFC in the US, this velocity was cut, let’s say, in half. Economic growth was negative for a while too, let’s say -1%. Therefore, the equation changed as such:

%∆M + -50% = %∆P + -1%

So, in order to achieve their target 2% inflation rate, the Federal Reserve would have to increase the money supply by 51%!

These numbers are just a guide. And they’re hard to estimate in real time. So the Federal Reserve had to do a bit of guess-and-check with their liquidity injections to see how it was affecting inflation. But it does show how they were able to inject so much liquidity into the system without causing the hyperinflation or the currency war about which so many were worried. V was decreasing just as fast as M was increasing. There was minimal flow through from quantitative easing to consumer prices, barely keeping inflation above zero, and not causing the US dollar to plummet.

And this is what the Federal Reserve was trying to achieve. Not real economic growth per se. They just wanted to avoid widespread deflation (which they did), which can be devastating to an economy, rather than actual inflation. And without fiscal support from the government (which would have restored V, thereby removing the need to increase M) or a financial sector that was willing to lend out all this extra liquidity, this is the only thing that kept the US economy from tail-spinning into a deflationary depression. Even if it didn’t kick-start real economic activity. Furthermore, any currency advantage the US achieved just by avoiding deflation (not even triggering inflation) is a tactic any central bank can (and should) employ during a crisis.

A different (though inextricably linked) way to look at this is through the Liquidity Trap Hypothesis. This is the idea that once interest rates have been dropped to zero but the economy is still depressed, additional monetary stimulus has no impact on short term interest rates and therefore, provides no additional economic stimulus. It just sits there.

Fiscal policy is needed to fill this gap. Additional monetary stimulus, at best, provides additional confidence regarding the financial system’s liquidity buffers (improving inflationary expectations). And if targeted at long term interest rates, it may encourage greater borrowing by households, industry and government beyond lower short term interest rates.

Fiscal stimulus though, rather than just driving up inflation and interest rates, and crowding out the private sector (as might happen during normal times), actually has great potential to kick-start real economic activity during an economic slump. But it didn’t happen.

This is why all this quantitative easing didn’t trigger inflation in the US. Nobody was spending it.